S
corporations have tax savings reasons to underpay shareholder-employees. While
all of an S corporation's earnings are subject to federal income tax, only
wages are subject to federal employment taxes. S corporations save FICA and
FUTA taxes to the extent that they do not pay wages to shareholder-employees.
The reasonable compensation issue for S corporations is the flip side of the
compensation issue for C corporation shareholder-employees. C corporations want
to pay large salaries to shareholder-employees to mitigate or eliminate the
double income tax issue for the corporation and its owners. S corporations want
to pay low salaries to save or eliminate employment taxes.
Who is required to receive reasonable
compensation?
In Rev.
Rul. 74-44, the IRS tried to prevent S corporation attempts to avoid employment
taxes by underpaying (not reasonably compensating) the shareholder-employee. In
the ruling, the IRS held that an S corporation that paid dividends but no
compensation to two shareholders who provided services to the corporation was
required to pay reasonable salaries to those shareholders.
Both
FICA and FUTA impose taxes on employers based on the wages they pay to
individual employees. The Acts define
“wages,” with some exceptions, as “all remuneration for employment....” Employment is “any service of whatever nature,
performed...by an employee for the person employing him....” Employee is defined by FICA as:
(1) Any
officer of a corporation, or
(2) Any
individual who, under the usual common law rules applicable in determining the
employer-employee relationship, has the status of an employee.
Employee
under FUTA, with some exceptions, has the same meaning as in Section 3121(d) of
FICA. 10 Reg. 31.3121(d)-1(b) restates the general rule that an officer of a
corporation is an employee of that corporation. The regulation also specifies
an exception for an “officer of a corporation who as such does not perform any
services or performs only minor services....” The FUTA and FICA regulations are
virtually identical.
Despite
these statutory and regulatory provisions, there is a long line of cases in
which shareholder-employees asserted that they were either not employees, and
thus not required to receive reasonable compensation, or that the distributions
that they received were for something other than compensation.
Many
factors must be considered when determining reasonable compensation for an S
corporation shareholder-employee. The complexity of identifying and taking into
account all of these factors is lessened when the taxpayer seeks and uses
collected and analyzed comparable industry data to establish the compensation
paid to the shareholder-employee. If such data are not used, factors on which
compensation is reasonably based must be considered. Owners should obtain the
data, file it, and follow it in paying shareholder-employee compensation. These
actions will be helpful in thwarting IRS efforts to refute the compensation
paid to the shareholder-employee. These actions also should serve to mitigate
or eliminate interest and penalties, avoid the time and costs of dealing with
the IRS and, for S corporations with two or more owners, reduce the risk of
loss of the S election.
Please call me if you
have any questions about these rules. Together we can make sure that you'll get
all the deductions to which you're entitled come next filing deadline. I look forward to hearing from you. Click
this link to view our YouTube video http://youtu.be/EYJdQtbPZAI
Amare
Berhie
(651)
621-5777, (952) 583-9108, (612) 224-2476, (763) 269-5396
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